Professional Service Profit and Loss Made Easy

By Jeanne Urich, Managing Director, Service Performance Insight, LLC

Step 2: Analyze revenue and costs

profit and lossThis is the second article in a three-part series examining the metrics that matter for running a professional services business. Part one looks at key metrics, typical targets and the incremental impact of small improvements. In this one, we provide descriptions and industry averages for the critical components of the professional services income statement — both revenue and expense. The third article will reveal the best practices and profit and loss statements of the top PS firms.

Based on eight years of benchmarking more than 2,000 professional service organizations, by far the most important questions and variances come from our income statement analysis. Both revenues and costs show enormous variability — not just for embedded versus independent services providers — wide variances are also seen across professional services verticals and different size organizations. There are no definitive right or wrong answers as services-based businesses are comprised of many different business models with varying sources of revenues and costs.

The secret success formula is based on maximizing the productivity and profit of each business line while limiting unwarranted overhead. Our research continually shows that the most successful services businesses are also the fastest growing. Early-stage service organizations are typically very decentralized while more mature organizations move to centralize critical overhead functions such as finance and operations, IT, PMO and resource management. Centralized overhead activities are typically less costly than decentralized.

Flat or negative growth in a services business is deadly because of the high cost of finding and retaining talented consultants. Without enough new and interesting work and clients, high-priced consultants will start looking elsewhere for new opportunities where they will be able to grow their skills and income.

Analyze your income statement
We recommend PS executives begin the process of profit improvement by analyzing their income statement, and comparing it to the 2015 Professional Services Maturity Benchmark. This comparison provides insights into where they can increase revenues or reduce costs to improve profitability. The following sections highlight the various components of the PS income statement.

Revenue sources
• Direct gross PS revenue – Directly delivered PS revenue that does not include re-billable travel.
• Reimbursable travel and expense revenue – The revenue recognized from re-billable travel and business expense.
• Indirect gross revenue – Revenue from subcontractors and other outside resources.
• Pass-through revenue – Revenue from hardware, software, materials, etc.

Costs
• Direct Labor expense – The cost of direct billable labor, not including fringe benefits, vacation, sick time or overhead. Non-billable labor expense for sales, marketing, IT, general and administrative, etc. should be shown in those categories.
• Fringe benefit expense -Typically this expense is based on a percentage of direct labor cost. It is the cost of employer-provided healthcare, pensions, vacation and sick pay for billable personnel.
• Billable travel and business expense – The cost of travel and business expense that can be billed. These costs may be equal to the revenue from rebilling travel and business expense. Most firms are not able to charge a mark-up on re-billable travel and business expense. They may however charge consultant time spent while travelling. Billings for consultant travel time should be shown in direct gross revenue. If the consultant is not engaged in billable work while travelling, travel time is typically charged at a lower bill rate.
• Non-billable travel and business expense – The cost of travel and business expense which cannot be billed to clients. Non-billable travel and business expense for business development should be included in the cost of sales. Costs shown here are typically for non-client related business travel for training, company meetings, etc.
• Subcontractor and outside consultant expense – The cost for non-employee contractors and outside consultants. This cost is offset by indirect gross revenue. Typically firms target 25 percent or more markup on subcontractors.
• Pass-through expense – Expense for hardware, software, materials, etc. that can be rebilled to clients. Typically firms mark up the cost of re-billable hardware, software and supplies to cover their procurement, handling and shipping costs. Typical target markup is 15 percent or more.
• Sales expense – This comprises the cost of sales headcount, bonuses and non-reimbursable sales expenses.
• Marketing expense: This includes the cost of direct and indirect marketing headcount, bonuses and marketing program expenses.
• Education, training and certification expense – The cost of education, training and certification expense across the organization.
• PS IT expense – All IT expense both capital and depreciation for the IT infrastructure including personnel, equipment, software, networking, etc.
• Recruiting expense – Direct and indirect headcount, costs and fees for recruiting.
• All other general and administration – The cost of all non-billable headcount not already shown in sales, marketing, IT or recruiting. Includes facilities, general and administration overhead.

Expense targets
We have found typical overhead expenses — as a percent of total PS revenue — should fall into the following ranges. If your expenses exceed the benchmark averages, your organization is most likely spending too much, which lowers profit.
• Direct labor expense (40 to 50 percent). Direct labor cost as a percent of total revenue.
• Fringe benefit expense (6 to 10 percent). Fringe benefit expense as a percent of total revenue.
• Subcontractor expense (7 to 15 percent). Subcontractor cost as a percent of total revenue. This number varies depending on the percentage of total revenue generated by subcontractors. In the 2015 PS Maturity Benchmark, subcontractor-generated revenue averaged 13 percent of top line revenue.
• Sales (2 to 20 percent).Includes all direct sales headcount and fringe benefits plus non-billable business development travel and expenses, commissions, incentives and sales training. Sales expenses are typically low for embedded PSOs because they rely on the product sales force to generate PS opportunities. Embedded PSOs are typically not allocated a corporate sales charge. There is tremendous variability in the cost of sales as many organizations rely on their consulting staff to develop business. In many cases, PSOs do not capture the true cost of business development; it may be represented as non-billable time for consulting staff.
• Engineering and project management organization (1 to 2 percent).This includes all PS engineering and PMO headcount; fringe benefits and expenses such as labs, tools, delivery training and project reviews. This expense should include the cost of non-billable time for consulting staff spent on improving tools, methods and infrastructure.
• Marketing (1 to 2 percent).This encompasses all services marketing headcount and marketing expenses, such as website, PR, advertising, trade shows, sales training, customer satisfaction survey, references and services packaging.
• IT (1 to 2 percent).Comprises all IT capital expense, depreciation and headcount costs. Embedded PSOs may receive a corporate per headcount IT allocation.
• Recruiting (1 to 2 percent). In today’s talent-constrained market, both recruiting costs and time to find and hire consultants are growing at an alarming rate. Most PSOs use a combination on in-house HR and external recruiters.
• General and administrative (5 to 20 percent).This includes PS corporate management, facilities and non-billable travel.

2015 PS Maturity Benchmark income statement

2014 was a good year for PS profitability. Profit for both embedded and independent services organizations increased as did the profit reported by all geographies. Average net PS profit for the entire benchmark increased to 13.2 percent in 2014 as compared to 11.4 percent in 2013. Embedded service organization (ESO) net profit increased to 19 percent from 15.4 percent in 2013. Independents saw profit increase slightly from 10 to 10.8 percent.

Table 1 compares the income statements of the 2015 Professional Services Maturity Benchmark for 220 professional services organizations. Sixty-seven are from embedded services organizations (ESO) and 153 are from independent professional services organization (PSO).

Table 1: PS Income Statement for Embedded and Independent Consultancies in Percentage
PS Income Statement Source: Service Performance Insight, September 2015

Although still not yet at pre-recession levels, most key financial metrics improved from 2013 to 2014. The bottom line is that profit improved almost across the board for professional services organizations in 2014. The benchmark shows strengthening demand, utilization and bill rates which led to higher revenue yield by consultant and employee.

With improved demand, PSOs did a good job of limiting non-billable overhead and discretionary spending. The overall PS market grew revenues at 10 percent, unchanged from the prior year but firms did a much better job of balancing supply and demand, leading to bottom-line profit improvements.

Focus on both revenues and costs
Above the line, revenue is driven by revenue by account, client or project. Revenue generated is typically based on the number of hours worked at an average bill rate. These are fairly easy numbers to get and report. Below the line, revenue is offset by labor cost and overhead. Yes, your organization can improve revenues while reducing costs.

Here are activities you might consider to improve revenue and cut costs:
• Focus on improving sales and marketing effectiveness to capture more installed base business while keeping a lid on sales and marketing expense.
• Add more strategic services that command higher rates. Focus on selling and delivering larger projects.
• Develop repeatable services packages to demonstrate client value and reduce the cost of sales and marketing.
• Create dedicated consulting sales and delivery roles. Excellence comes from specialization. Immature organizations may be spending more and getting less by employing a jack of all trades model in which everyone sells and delivers.
• Invest in superior talent. Winning and keeping top clients is based on providing top consultants with unique insights. Arm them with proprietary tools, methods and knowledge that enhance client success and ROI.
• Tightly measure and manage consultant billable utilization and bill rates to drive high productivity.
• Provide rewards and recognition to enhance employee engagement.
• Keep a tight lid on overhead and fixed costs by reducing facility costs and limiting non-billable roles while investing in systems and tools to automate time capture and billing.
• Ensure clients are satisfied and willing to be a reference.

Professional services organizations that focus on understanding and improving their income statement generally perform at higher levels and grow faster and more profitably than those that do not. They invest in services that offer both growth and profit potential, as well as in the talent who will ultimately deliver superior results.

Invitation to Complete the 2015 Global PS Pricing Survey

What You Need to Know About Professional Services Bill Rates
The art and science of services pricing
by Jeanne Urich, Managing Director, SPI Research

Services teams concentrate on utilization and less on rate realization. Focusing on pricing strategy is the key to doing more with less to achieve persistent profitability.  The 2015 Global Professional Service Pricing research helps services organizations understand how they measure up, where they can improve to increase margins and how they can properly position their services in the market.

To participate in the 2015 PS Global Pricing survey, please visit http://www.spiresearch.com/spi-research/2015-ps-pricing-study/
Professional service organizations who complete the survey will receive a free copy of the benchmark.

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The study will provide an analysis of list price and realized bill rates across a broad range of professional services verticals, geographies and job levels around the globe. It will analyze the growing trend toward more offsite consulting delivery and the prevalence of different pricing structures. The report will provide a view of professional services workforce distribution and composition by industry segment through an analysis of organization structures for various service segments including management consulting; IT consulting; software and SaaS; VARs and hardware and networking services.

What the 2011 pricing benchmark revealed

The major takeaway from Service Performance Insight’s 2011 Global Professional Services Pricing study is that success comes from the right combination of pricing policies along with outstanding services delivery quality and workforce efficiency. The two primary profit levers professional services organizations possess are bill rates and workforce productivity, often called billable utilization. PS organizations tend to concentrate more on productivity, often ignoring price improvements. Efforts to enhance price realization can produce both instantaneous and sustainable profit improvements.

The cause and effect of higher bill rates

Price realization based on realized bill rates in combination with billable utilization is a leading indicator of the overall quality and differentiation of the PS organization. Professional services organizations with the highest bill rates and best price realization tend to reinvest profit into their employees, which in turn, leads to a continuing improvement cycle.

Highly skilled, well-trained, motivated and loyal consultants undoubtedly produce the best client results. Satisfied clients provide referrals and buy additional services resulting in improved sales effectiveness.

Based on nine years of benchmark data, one of the consistent themes is the correlation between high bill rates and employee investment resulting in superior project delivery metrics and overall financial profitability. Bill rates, however, only tell a part of the story.

The market, the types of services provided and the reputation of the firm primarily govern rates. Management consulting senior partner daily rates are as high as $8,000 while Indian software development resources are priced as low as $25 per hour.

The top strategic management consultancies don‘t publish their rates, nor do they make them visible to their clients. These rates are justified based on the significant “bet your business” types of projects these firms deliver. High rates indicate the strategic business value top firms provide.

At the other end of the spectrum, the lowest bill rates are shown in commoditized hardware installation and repair, where providers mainly focus on implementation. Staff augmentation garners low rates because the client assumes almost all of the responsibility for successful business outcomes. Clients are buying a body with a specific skillset as opposed to a project based on a measurable business results.

Differentiation, specialization and market growth drive rates upward while commoditization and shrinking market demand drive rates down. The law of supply and demand is clearly evident in the pricing report because software as a service (cloud) services now command a 20 to 30 percent premium over traditional enterprise software bill rates.

Why is pricing important?

In a labor-based business like professional services, profit comes from the right balance of revenue and costs. PSOs have a very high fixed labor cost so the two primary profitability levers are either lowering cost (employee and subcontractor sourcing strategies, limiting benefits and overhead, using virtual business models and restricting discretionary spending on IT, travel, training and recruiting) or increasing revenue (higher bill rates, higher revenue per person, higher billable utilization and a higher proportion of billable headcount).

Throughout the recession, PSOs focused intently on the cost side of the equation. Now with economic improvement, they are concentrating on growing revenue through a combination of rate, market expansion and productivity enhancements.

Professional Service Pricing Strategies

Pricing strategies vary dramatically by market and geography. European PSOs prefer daily rates which may or may not include travel expenses. The percentage of time and materials priced contracts across all markets and geographies was reported to be almost 60 percent.

Every year a greater proportion of contracts across all verticals and geographies are fixed price reflecting client interest in shifting more risk and accountability to services providers. Table 1 shows a comparison of pricing strategies across PS vertical markets. It reveals IT consultancies and PSOs within software companies depend heavily on time and materials based pricing strategies.

Hardware and networking providers and SaaS PSOs have shifted the majority of their work to services packages and fixed price contracts while management consultancies favor time and materials based contracts, but may include performance guarantees.
Table 1. Pricing Structure by Organization Type
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Future expectations for bill rates
All signs point to an unstable global economy for some time to come. Bill rates are not uniform around the world. Across the board, global consulting bill rates have been relatively stagnant while target utilization rates have continued to climb. The key question is how can the professional service industry sustain a business model where employees and subcontractors must be billable 75 percent or more of their time?
Will the pressure to work excruciating hours subside with the shift to a global and virtual economy? As the reality of increased consulting demand outstrips available supply, expect to see average billable hours to continue to increase, perhaps to a breaking point. Rates for the hardest to find resources are climbing.

Around the world, a significant price disparity exists for the same job skills within the same industry segments. If an organization can establish its brand and reputation as the highest-quality supplier in its market space, it can command the best rates.

Conversely, for services providers stuck in a commoditizing rut, the only viable strategy is to head for higher ground by expanding into a more lucrative market. For example, low-end enterprise resource planning providers will find new opportunities and premium rates if they add vertical expertise or take on new cloud technologies and services. Research indicates the unlimited possibilities for establishing new, exciting and profitable service lines will require significant leadership, vision and courage.

Bottom line, the consulting industry is thriving. Expect not only a heightened focus on bill rates, but also significant labor shortages ahead. Top performing firms will focus on both recruiting and retaining top talent while making sure they take advantage of premium pricing to fund these investments.